Reviewing the Operating Pro Forma
Accurately and realistically projecting operating costs in HOME and LIHTC projects is important because the project’s long-term financial viability will be impacted if there are inaccuracies in the projected costs and revenues. The pro forma should encompass all stages of the project—from lease-up to stabilized operations, and throughout the affordability period.
Exhibit 2-6: Sample Multi-Year Operating Pro Forma
In the example illustrated by Exhibit 2-6, the first year is not stabilized (meaning that the property has not yet achieved full occupancy) and it produces a loss of ($55,000). Typically, this “lease-up” expense would be paid through a reserve established specifically for this purpose, and it would be funded as a development expense of the project.
In addition to its standard review of the operating pro forma, the PJ should pay special attention to the following elements of the pro forma in a HOME-LIHTC project:
- Unit mix
- The reasonableness of the gross potential rent projections
- The reasonableness of operating expenses, including whether they are sufficient to ensure the long-term success of the project
- Trending assumptions about the inflation rate for revenues and expenses.
The term unit mix refers to the range of unit types, sizes, and rents and occupancy restrictions that are proposed to be included in the HOME-LIHTC project.
The PJ determines the minimum number of units which must be designated HOME-assisted based on the amount of HOME investment in the project and the maximum per unit subsidy for the area. This process is known as cost allocation. Attachment 2-3, located at the end of this chapter, illustrates how to use cost allocation to determine the minimum number of HOME- assisted units in the project. The PJ may designate a greater number of HOME units than the minimum required. The PJ also determines how many units must be designated High HOME Rent and Low HOME Rent units in the project. In projects with five or more HOME-assisted units, at least 20 percent of the units are designated as Low HOME Rent units. Again, the PJ may designate more than 20 percent of the units as Low HOME Rent units if it so chooses. The remaining units are High HOME Rent units. See the section below for more information about rents.
The number of units that are designated as tax credit units is stated in the use agreement with the state allocating agency. This must either be a minimum of 40 percent of the units when the occupancy is restricted to households with incomes at or below 60 percent of area median income (AMI), or 20 percent of the units when occupancy is restricted to households with incomes at or below 50 percent of AMI. Many tax credit project owners designate all the units as LIHTC units, because the greater the percentage of tax credit units, the greater the amount of tax credits that can be allocated to the project.
The developer and PJ face the decision whether to add the HOME restrictions to units that are subject to LIHTC rent restrictions, or to apply the HOME restrictions to units that are not LIHTC-restricted (if any). This decision may be impacted by what the HOME and LIHTC rent limits are, the market rents, and the financing impact of overlaying rent and occupancy restrictions to achieve greater tax credit equity.
It is helpful to generate a unit mix table that summarizes key unit mix information:
- Number of units of this type
- Number of bedrooms
- If there is more than one type of unit with this number of bedrooms, additional information identifying this particular unit type (for example, number of baths, whether there is a den, or affordability level)
- Rental square feet
- Gross potential rent
- Whether the unit rent is subject to LIHTC rents, High HOME rents, Low HOME rents and/or other rent restrictions
- Whether any utilities are tenant-paid, and what utility allowance applies (estimate for the monthly cost of tenant-paid utilities).
Exhibit 2-7 provides a sample of how this information can be presented.
Exhibit 2-7: Sample Unit Mix Table
Since both HOME and LIHTC units carry rent restrictions, it is critical that the PJ’s underwriters verify that the correct rents are being used in the rent projections. The rent projections that should be used will depend on:
- The unit mix (i.e., how many units are designated High HOME Rent units, Low HOME Rent units, LIHTC units, and both HOME and LIHTC units)
- The current High and Low HOME Rents and LIHTC rent limits for the jurisdiction, and whether or not the tenant pays for utilities
- The estimated market rents for the project.
HOME and LIHTC Rent Limits
Both HOME and LIHTC require that the rents that are charged for assisted units are affordable to income-eligible households. Each program issues its own rent limits to define what is affordable. The rent limits represent the maximum rents that can be charged to income-eligible households. The cost of any tenant-paid utilities must be deducted from the published rent limit to determine maximum rents that can be charged. Each program issues utility allowances for this purpose— these represent the average utility cost for the area.
For each specific unit(s), the PJ’s underwriter uses the following guidelines to determine the rent limit that applies:
- HOME rent limits apply to units that are designated as HOME-assisted units only.
- Tax credit rent limits apply to units that are designated as tax credit units only.
- The lower of the HOME or LIHTC rent limit applies to units that are designated as both HOME and tax credit.
If the estimated market rents for HOME or LIHTC units are below the program-restricted rent limits, the underwriter should use the lower, market rent in underwriting the project. Simply because a rent is restricted does not guarantee that it is below-market, and tenants will never pay above-market, restricted rents.
If the project has any market rate units (that is, units are neither HOME- nor LIHTC-assisted), the estimated market rate rents should be used.
In projects that serve persons with special needs, it may not be possible for a unit to carry a HOME- and LIHTC-assisted designation and still be in compliance with the program’s requirements related to serving the special needs group. See Chapter 4 for a more detailed discussion of this issue.
Basis of the Rent Limits
HUD issues HOME and LIHTC rent limits and adjusts them for different localities and for each bedroom-size unit from zero (efficiency) to six bedrooms. HUD updates the HOME and LIHTC rent limits every year.
High HOME rent limits are based on the lesser of one of the following:
- The Section 8 Fair Market Rents (FMRs) for existing housing
- 30 percent of the adjusted income of a family whose annual gross income equals 65 percent of AMI.
Low HOME rent limits are based on one of the following:
- 30 percent of the tenant’s actual adjusted income
- 30 percent of the annual gross income of a family whose income equals 50 percent of AMI (this is the HUD-issued Low HOME Rent)
- If a property has a Federal or state project-based rental subsidy and the very low-income tenant pays no more than 30 percent of his or her adjusted income toward rent, the maximum rent allowable under the project-based rental subsidy program.
Note that Low HOME Rents are used in the units that must be occupied by very low-income occupants in properties with five or more HOME-assisted units. Low HOME Rent units must represent at least 20 percent of the units in projects with five or more HOME-assisted units. Most PJs use the HUD-issued Low HOME Rents, unless the project has a project-based rental subsidy.
LIHTC rent limits are based on one of the following:
- 30 percent of 50 percent of AMI, when units are restricted to this population
- 30 percent of 60 percent of AMI, when units are restricted to this population
- 30 percent of a lower AMI, as required by the project-specific use agreement.
For a unit that serves to meet both the HOME and LIHTC requirements, the rent cannot exceed the FMR, because the FMR serves as a ceiling rent for the HOME Program. State allocating agencies update rent limits annually based on HUD-issued income limits.
Using Utility Allowances
In projects where the tenants pay for some or all of the utilities, the PJ’s underwriter must deduct the anticipated utility allowances from the rent limits to determine the maximum rent that can be charged for the unit. Failure to do this will result in an over-estimate of the potential gross rents of the property since utility costs can impact the rent figures significantly.
LIHTC and HOME may use different utility allowances. The LIHTC utility allowance must be deducted from the LIHTC rent limit to determine the maximum allowable LIHTC rent. The PJ’s utility allowance must be deducted from the HOME rent limits to determine the maximum allowable High HOME Rents and Low HOME Rents. The PJ can choose to adopt the LIHTC utility allowance for its tax credit projects, to simplify this process. For each unit that is designated as both a HOME and LIHTC unit, the lesser rent limit is used after utility allowances have been deducted.
Affordability and Market Rents
It is risky to assume that the property will achieve its “use-restricted” rent limits. The PJ should always compare the HOME and LIHTC rent limits to the market rents in the neighborhood. In some communities, the rent limits imposed by the LIHTC and HOME Programs will result in a higher rent for a unit than the market will actually bear. For example, a unit might have a maximum tax credit rent of $660 after utilities, a maximum HOME rent of $625 after utilities, and a maximum market rent of $500. Regardless of the program rent limits, the property cannot charge more than the market will pay, or $500. This lower market rent complies with the LIHTC and HOME rent restrictions, because it is always acceptable to set rents lower than the rent limits.
Expenses that Help Ensure Long-Term Success
Both HOME and LIHTC require compliance for some period of time after construction completion. Certain line items impact the longevity and long-term financial viability of the project. The PJ should be sure that these line items are sufficient to meet the project’s needs over the long term:
- Maintenance budget
- Property management
- Reserve for replacements.
Preventive maintenance helps ensure that major systems meet their useful life. Operating budgets should provide for adequate ongoing maintenance.
Sufficient property management fees help attract and retain qualified and competent property managers. Managing a HOME-LIHTC project requires understanding and complying with requirements of two different programs, and includes annual income certifications, periodic property inspections, implementing rent restrictions, and organized recordkeeping systems. The PJ should expect to pay more for a property manager of this type of project than it might for smaller projects, or for projects that are HOME-assisted only. PJs should be careful not to underwrite to below-market property management fees, even if such fees will be charged to the project initially. Doing so may leave the property without enough breathing room in its operating expense budget to replace a failing management agent with a qualified agent, at prevailing prices.
Replacement Reserve Deposits
Replacement reserves are payments made in escrow to cover the costs of capital needs and major systems repairs and replacements that occur as the property ages. For example, this might include the need to replace appliances, air conditioners, water heaters, and roofs. The state allocating agency and/or the first mortgage lender may have guidelines about the level of Reserves for Replacements. The PJ should not adopt these guidelines without making its own assessment of whether the required replacement reserve is sufficient. Without sufficient reserves, as these properties age, they will need to supplement the replacement reserves with some combination of excess future cash flow, refinancing proceeds, or new government subsidy.
The Replacement Reserves estimate should be based on a capital needs assessment, whenever possible. Attachment 2-1, found at the end of this chapter, discusses how to prepare a capital needs assessment.
Assumptions about Inflation
In affordable rental housing underwriting, it is prudent to assume that revenues will grow at a slower rate than expenses. Depending on the relative growth assumptions for revenues and
expenses, NOI may actually decline as the property ages. This could be a serious problem for HOME-LIHTC properties that must comply with affordability restrictions for some period of time.
The following exhibits illustrate the impact of using the same income and expenses, but different assumptions for long-term inflation rates; they illustrate how these assumptions impact cash flow. Exhibit 2-8 shows inflation assumptions that are typical for market rate apartments, where the inflation rates assumed for revenues and expenses are the same. Exhibits 2-8 and 2-9 illustrate the effect of lowering the inflation rate assumption for revenues, while holding the inflation rate for expenses constant. In the third illustration, in which income is projected to rise at 2 percent per year while expenses increase at 3 percent per year, cash flow starts to decline after about Year 10.
Exhibit 2-8: Illustration with Equal Inflation Rate for Revenue and Expenses
(3% Inflation for Revenue, 3% Inflation for Expenses)
Exhibit 2-9: Illustration with Lower Inflation Rate for Revenue than for Expenses
(Assuming 2.5% Inflation for Revenue, 3% Inflation for Expenses)
Exhibit 2-10: Illustration with Lower Inflation Rate for Revenue than for Expenses
(Assuming 2.0% Inflation for Revenue, 3% Inflation for Expenses)
These illustrations demonstrate how seemingly small differences in the trending assumptions can have a very significant impact on the outcome of NOI and cash flow over time. There are significant implications for HOME-LIHTC projects. In many HOME-LIHTC projects, conservative underwriting indicates that expenses will increase at a faster rate than income (rents), because of the market, the proposed project’s regulatory structure, and the restrictions on rents that can be charged. In these projects:
- The project will probably need a larger debt service coverage ratio (DSCR) at the beginning, so that if NOI growth becomes negative at some point in the future, there will still be an adequate operating margin.
- The monthly deposits to the Reserve for Replacements will probably need to be increased, because there is much less likelihood that there will be available future cash flow to pay for some long-term capital needs.
- The first mortgage loan should probably have a shorter rather than longer period of amortization, so that principal will be paid down quickly, ensuring that the project will be able to refinance if necessary.
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